Understanding Nonelective Contributions: Benefits and Drawbacks

What Is a Nonelective Contribution?

Nonelective contributions are employer-funded additions to employee retirement plans, independent of employee contributions. This proactive approach enhances employee savings and meets compliance standards while potentially lowering administrative burden. Discover how nonelective contributions work, their benefits, and considerations for both employees and employers.

How Nonelective Contributions Work

Nonelective contributions can vary. For example, a company might contribute the equivalent of 3% of each employee's salary toward their employer-sponsored retirement plan. If an employee earns $50,000 per year, for example, the employer would be contributing $1,500 per year, no matter what the employee contributes.

The IRS sets annual contribution limits, which nonelective contributions cannot exceed. In 2024, if you're under 50, you can contribute up to $69,000 to a defined-contribution plan like a 401(k). Those 50 or older can add $7,500 in catch-up contributions, totaling $76,500 for 2024.

Benefits of Nonelective Contributions for Employers and Employees

Benefits for Employers

Nonelective contributions come with advantages for the employer. They are tax-deductible, and they can encourage more employees to participate in the company's retirement plan. The decision to offer fully-vested nonelective contributions can also provide retirement plans with safe harbor protection, which exempts plans from government-mandated nondiscrimination testing.

The IRS administers these tests to make sure plans are designed to benefit all employees instead of favoring highly compensated ones. Making nonelective contributions can help employers meet this goal while also remaining compliant with government rules.

Employers' nonelective contributions must be at least 3% to achieve IRS safe harbor status. A company can opt for safe harbor provisions, such as nonelective contributions before the plan year ends. They can also decide to elect safe harbor provisions for the year generally 30 days before the end of the plan year.

Benefits for Employees

Employers make nonelective contributions to employees' accounts whether or not employees make contributions, which benefits the employees. The employees don't have to do anything to receive this benefit.

Potential Drawbacks of Nonelective Contributions for Employers and Employees

Drawbacks for Employers

Offering nonelective contributions may add administrative costs, which might not suit all employers. Making nonelective contributions also means flowing money into default funds for employees who don't manually enroll in a plan and select a fund or make contributions. As fiduciary plan sponsors, employers would need to take due diligence in selecting these funds.

To make this simpler, the Pension Protection Act of 2006 outlined its qualified default investment alternatives (QDIAs) and how employers can enroll workers in these funds while gaining safe harbor protection. QDIAs are defined as target-date funds (TDFs) or lifecycle funds, balanced funds, and professionally managed accounts.

However, a TDF isn't a one-size-fits-all solution for all employees. Employers still need to take a thorough look at their workforce to determine appropriate plan menu funds and QDIAs to remain compliant with government regulations and to help employees secure a comfortable retirement.

Drawbacks for Employees

Employees might receive less from a nonelective contribution than from a matching contribution, which can be 5% or more.

The Bottom Line

Nonelective contributions provide a valuable opportunity for employers to enhance their employees' retirement savings without requiring employee contributions. These fully vested contributions also offer tax benefits and can help employers meet compliance standards, such as safe harbor provisions, which protect plans from discrimination testing.

However, employers should weigh the potential administrative costs and consider whether this approach aligns with their financial goals and workforce needs. For employees, while nonelective contributions ensure savings, they might result in less total employer contribution compared to matching contributions, which can sometimes be higher.